More Than Ever, Stock Investors Are Thinking Like Owners

Shareholder Tactics

There are two ways for investors to affect corporate behaviour: from the outside and from the inside.

The common approach is from the outside. Should equity shareholders become unhappy, they generally sell their stake rather than attempt to engage with the company’s management. That principle holds even more strongly with fund investors. Disenchanted fund customers don’t send instructions to their portfolio managers. Instead, they redeem their shares.

The other tactic is to influence companies from within, by using one’s position as a shareholder to encourage corporate managements to change their ways. Sometimes, this occurs aggressively, with large shareholders running candidates for the board of directors, while publicly criticizing the company’s direction. Other times, the effort comes quietly, with investors nudging businesses through private conversations, during which they share their concerns.

Tactic Number 1: From the Outside

First, a note about the traditional shareholder strategy of voting with one’s feet by selling disliked equities rather than talking with corporate management. As with all motivational techniques, this strategy relies on correct execution. Incentivizing management through transactions does no good if those trades are misplaced. For example, during 2020 and 2021, US investors poured $230 billion into special-purpose acquisition companies—organizations whose founders, after receiving sweetheart deals, were permitted to use the incoming assets almost solely as they wished. Is it any wonder that SPAC returns have since been poor?

Most of the time, though, the system works. For many years now, stock market critics have argued that investors have unduly rewarded a handful of glamorous technology companies. Consider the FANG stocks, as the term was coined in 2013—Facebook (now Meta Platforms META), Amazon.com AMZN, Netflix NFLX, and Google GOOGL. Many suggested at the time that their skyrocketing prices were speculative. Since then, Meta and Amazon have grown their profits more than fifteenfold, and Alphabet fivefold. Only Netflix has stumbled, although recently its ship has sharply righted.

Similarly, fund investors have learned from their mistakes. As I detailed in Index Funds Have Officially Won, experience taught fund shareholders how to be excellent stewards. These days, aside from a small group that speculates in esoteric exchange-traded funds, their portfolio holdings are thoroughly sensible and sober.

Tactic Number 2: The Inside Path

Although generally successful, the outside approach benefits by being paired with an inside strategy. For the latter, the time-honoured approach has been through “activist” investing. Either an extremely wealthy individual or, more likely, a hedge fund buys enough shares to earn a hearing. The activist then attempts to secure one or more seats on the corporate board, from which it can advance initiatives. Typically, these proposals involve near-term strategies, such as cost-cutting or putting the company up for sale.

In recent years, so-called ESG investing, which addresses environmental, social, and governance issues, has supplemented activists’ endeavours by also encouraging outside shareholders to become involved with corporate affairs. The key term is “governance.” Most institutional investors had already incorporated aspects of ESG into their decisions because it’s hard to be a professional shareholder without considering how businesses are managed. But by their own admittance, the ESG movement has increased those efforts.

The final mechanism for internal persuasion is by far the largest: index funds. They represent a new version of ownership. Because index funds cannot rid themselves of unwanted securities, they must either operate from the inside or not at all. The nature of their counsel has thus far been unclear since it has largely occurred within closed doors, but its power is indisputable. In aggregate, Vanguard, BlackRock BLK, and State Street STT own about 20% of listed US companies. Index funds have the muscle, should they wish to exercise it.

How ESG Changed Proxy Voting

Whether one agrees with the goals of ESG proponents does not change the fact that they think like owners. Their screens are not merely negative, to avoid companies that they dislike. That was the strategy of their predecessors, “socially conscious” investors, as well as of various affinity groups, such as religious organizations that boycotted tobacco and liquor companies. But the ESG movement includes campaigning for change from within.

In doing so, ESG proponents have attempted to enlist the index funds, lobbying the latter to use their proxy votes in a fashion that the ESG movement regards as constructive. As ESG’s opponents hold the opposite view, that effort has become a political battleground, with (for example) BlackRock’s institutional investment wing rebuffed by pension funds from several politically conservative states, which have disliked the company’s pro-ESG stance.

Looking Forward

The resistance has stung, making BlackRock and its rivals more reluctant to vote on shareholder proposals. The index providers’ retreat, I believe, is merely a temporary step backward for shareholder engagement. It is appropriate that index-fund providers, which after all hold shares only on behalf of others, hesitate to express their views too assertively. Not only do they serve many masters, many of whom have conflicting opinions, but they are not the stocks’ true owners. In such a position, discretion is well merited.

The better solution, surely, is to permit index-fund investors to vote their own shares. To no great surprise, Vanguard, BlackRock, and State Street are each experimenting with ways to give index-fund investors more voting options. At this stage, the implementation is clumsy. But that will change.

Here is where I think the technology will go. Index-fund investors who desire to vote their shares will have a short conversation with an artificial intelligence routine. Subsequently, the AI program will vote the investors’ proportional interests in the funds according to their wishes, as interpreted by the AI routine. (Of course, investors will be able to review those votes and alter them if desired.)

Equity investors are already thinking more like owners. Technology improvements figure to accelerate that trend.